Cost Reducing Project

1. Suppose a firm is considering a labour saving investment. In year 0 a

project required a 6,300 investment in equipment ( all figures are in
thousands of dollars). This investment is depreciated using the straight-
line method over five years and has a salvage value in year 5 of 1200.
With or without the cost reducing investment, all cash flows start in year
1 and end in year 5. The inflation rate, real growth rate , real cost of
capital and tax rates are given in the table. Forecast these assumptions by
considering both growth rate and inflation rate. Forecast the cost of
capital by considering inflation rate
[ note:(1+ inflation rate)*(1+real cost of capital)-1 ]
Key Year 0 Year1 Year2 Year3 Year4 Year5
assumptions
Inflation rate 3% 2.8% 2.5% 2.2% 2%
Real cost of 9.5% 9.3% 9.1% 9.0% 8.9%
capital
Real growth 16% 13% 9% 7%
rate
Tax rate 38% 38% 38% 38% 38%

Without present cost reducing investment the firm’s existing investments will
generate revenues, labour costs, other cash expenses and depreciation are given
in the table.
Without cost reducing With cost reducing
investment investment
Revenue 11500 11,500
Labour cost 3200 1300
Cash expenses 4500 4500

Company is planning to reduce the labour cost by reducing the number of

employees. The revised labour cost of year I will be 1300 and revenues and
other cash expenses will remain the same. What is the cost reducing projects
NPV?
Analyse the sensitivity of the project NPV to its labour costs
(900,1100,1300,1500,1700 ).
Solution: forecast revenues and expenses both with and without the cost
reducing investment. Calculate the net cash flows both with and without the
cost reducing investment. Subtract ne from the other to obtain the incremental
deference due to investment. Discount the project net cash flows back to the
present and determine NPV.
Use goal seek to analyse the sensitivity analysis.

2. Suppose a firm is considering a labour saving investment. In year 0 a

project required a 11,700 investment in equipment ( all figures are in
thousands of dollars). This investment is depreciated using the straight-
line method over five years and has a salvage value in year 5 of 4500.
With or without the cost reducing investment, all cash flows start in year
1 and end in year 5. The inflation rate, real growth rate , real cost of
capital and tax rates are given in the table. Forecast these assumptions by
considering both growth rate and inflation rate. Forecast the cost of
capital by considering inflation rate
[ note:(1+ inflation rate)*(1+real cost of capital)-1 ]
Key Year 0 Year1 Year2 Year3 Year4 Year5
assumptions
Inflation rate 0.0% 2.6% 2.2% 1.8% 1.4%
Real cost of
capital 8.7% 8.4% 8.1% 7.8% 7.5%
Real growth
rate 21.3% 17.4% 13.4% 9.5%
Tax rate 41.0% 41.0% 41.0% 41.0% 41.0%

Without present cost reducing investment the firm’s existing investments will
generate revenues, labour costs, other cash expenses and depreciation are given
in the table.
Without cost reducing With cost reducing
investment investment
Revenue $15,200 $15,200
Labour cost $4,100 $1,600
Cash expenses $5,300 $5,300

Company is planning to reduce the labour cost by reducing the number of

employees. The revised labour cost of year I will be 1600 and revenues and
other cash expenses will remain the same. What is the cost reducing projects
NPV?
Analyse the sensitivity of the project NPV to its labour costs
(900,1100,1300,1500,1700 ).

Solution: forecast revenues and expenses both with and without the cost
reducing investment. Calculate the net cash flows both with and without the
cost reducing investment. Subtract ne from the other to obtain the incremental
deference due to investment. Discount the project net cash flows back to the
present and determine NPV.
Use goal seek to analyse the sensitivity analysis.
 BREAK EVEN ANALYSIS
A project has a fixed cost of 30,000 variable cost of 4.00 per unit and generates
sales revenue of 6 per unit. What is the break even point in unit sales. Where
accounting profit exactly equals to zero and what is the intuition for it?